Emergency Savings Fund: Why, How Much, and Where?

A Comprehensive Guide to Emergency Savings

In a recent post on where to allocate your cash flow, I highlighted that step 1 should be to start an “emergency” savings fund. Starting an emergency savings fund is one of the fundamental building blocks in building a personal finance foundation for yourself. Many personal finance gurus agree that this is one of the first things you should do, ranking ahead of paying off high interest debt. It’s not a flashy topic, but smart personal finance has little to do with flash. This post will cover why you need emergency savings, how much you need, and where to put it.

Why Save for Emergencies?

There are a number of situations that arise in life that you simply do not have control over. Should these situations require immediate cash flow, it is essential to have emergency savings to cover it. If you have a personal investing account or retirement account you could pull funds from these, but for a number of reasons including bad market timing, early withdrawal penalties, or a delay in the liquidity of actually selling your investment and receiving your funds, this is the last thing you want to do.

Having money set aside for emergencies not only prevents this from happening, but also gives you the peace of mind that if something unfortunate was to happen that you will have a little financial cushioning to ride it out.

What Types of Situations May Require Emergency Savings?

I’m sure that you have needed fast cash for a number of situations in your life, or seen situations where others have. Insurance may cover many of these scenarios for you, but there is always a chance that it won’t cover fully what you will need. Here are a few examples:

lost job or layoff

began a new job that required you to expense a geographic move

auto accident, auto retirement, or major repair

major home expense such as a broken water line, tree falling on your roof, fire, natural disaster effects, etc.

pet health care

unexpected taxes owed to IRS

death in family that required you to help pay for funeral and other expenses

unexpected medical expenses not fully covered by insurance

How Much Should you Put in Emergency Savings?

This is where the experts tend to differ. There are a wide range of guidelines out there for how much you should save. Pick one or a combination, but ultimately, you have to choose an amount that you’re comfortable with and that feels right for you. Here are some of the general guidelines out there:

2-3 months worth of take home salary

6 months worth of living expenses

Start small and pay off debt before building 3 to 6 months worth of living expenses. Dave Ramsey falls into this camp. He advocates starting with $1,000, paying off all of your debt, then building a six month emergency fund.

8 months worth of living expenses. In the Laws of Money, the Lessons of Life, Suze Orman told readers that the 6 month time frame was no longer enough and that you should have “8 months of cash saved”.

I believe in a combination of the above, with a little twist. I think it is wise to start small and work your way up, as Ramsey recommends, however, I don’t think it’s realistic or wise to pay off ALL of your debt before saving more than $1,000. Focus on paying off high interest debt, but when it comes to school loans and mortgages, paying all of those off first before adding to your emergency savings is not a good idea. Once you’ve paid off high interest debt, then shoot for a minimum of six months of expenses.

Here’s where the twist comes in – if you are anticipating a major life changing event coming up, add to your fund or simply another savings account. You do not want to be pulling from emergency funds to pay off anticipated expenses.

Where Should you Put your Emergency Savings?

You should be earning interest from your savings, otherwise, you are losing value due to the effects of inflation. Place your emergency fund into a high interest savings account, checking account, or money market account (MMA). Stay away from certificates of deposit because if you pull your money out prior to the CD expiring, you will lose interest in the form of a penalty.

Go with a bank that offers quick and easy access to your fund and a competitive rate. The 4 online banks with a wide variety of product offerings and the highest savings yields are usually Discover Bank, Ally, EverBank, and Capital One 360. These banks still offer free checking accounts and debit cards. Use this as a starting point to see what the current going rate is before committing. Check back periodically to see if you’re getting the best going rate. If you’re not, don’t be afraid to switch. If you haven’t already, start building your emergency savings. It will help you sleep better at night.

There is also a case for putting your emergency savings in an ETF with a discount online brokerage. If you need to access the funds, you can have them within a few days via a bank transfer (and use credit cards in the meantime, which buys you time). The caveat with this is that if the market declines, you must replenish your base amount.

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20 Comments

Trevor

I like to keep about $5000 in an HSBC online savings account, but some circumstances that have come up this year have depleted a good portion of the emergency fund. This of course has lead me to believe that at this point in my life I need to have closer to $10,000.

I found somebody that thinks and does like me. I managed to save actually 10 k. But 50% of that money belongs to me and my wife and the other 50 % to my two sons .

Trevor , should you pay more debt monthly with your free income that will make you save more money . You must save between 20 to 35 % of your income.

I keep my emergency money (ER) in a security box in my personal bank. I am not worried about investing my ER money. That money is reserved for unexpected expenses. I always should keep 5k as a minimum in my savings account and there is no maximum.

Once you have control of your savings you should consider a real estate or a penny stock investment and/or EE treasury bonds . 40% of my portfolio will be in cash ,30% in stock or real estate debt and 30% in treasury bonds.

I started building an emergency fund about 6 months ago and have around $3k saved up. I’d like to see that at $10k by the end of this year, I’m working a second job this summer in order to have a little extra income to throw toward that. Currently its sitting in a savings account at USBank, only because that’s where my checking account is set up so I can easily transfer money online. Once I get $4k – $5k I’ll start looking more seriously into money market accounts – I did a small amount of research a few months ago and found that many require $5k to $10k in order to avoid fees, I figured I’d do more extensive research when I have closer to that amount saved.

I don’t exactly have an emergency fund, but I have been putting a good amount into mutual funds outside my 401k. I did this to start saving for a down payment on a house, & mutual funds seem liquid enough to convert into a down payment. Being early in my investing, it seems like overkill to have an emergency fund separate from the funds I’m saving for a down payment.

This article makes a compelling case for having liquid funds available, but I guess I’m not convinced it’d be better to split my non-401K savings between mutual funds & an MMA. Are MFs not liquid enough to handle all of the ’emergencies’ cited above? It seems almost all those items could be put on a credit card giving you 30 days to convert MF to cash and pay them off without penalty. Yes, market timing may not be ideal to sell the MF, but I don’t see why MMAs are significantly better.

I got $3000 right now and I am hoping to get it to $6000. It is at ING Direct. I would not worry about interest really this money is not about earnings it is just about a safety net besides there is no place you are going to put it that will yield a high enough interest rate to keep up with inflation and still be liquid. You are going to pay taxes on the interest made and that means if inflation is figured at 6% annually you will have to be around 9% and I have yet to find anything around that, that would allow immediate access to the money without penalty.

Micheal-
The downside to that (depending on your investments in emergency) is not the lack of liquidity (most likely at most 4 business days in your case) but rather “timing risk”. The risk that your water heater/furnace/car/muffy-your-favorite-dog needs a sudden wad of cash thrown at it just as the market decides to shed 3%… I would much rather pull money out of a seperate cash account (savings, mma, etc.) than sell-at-the-bottom (noone gets rich doing that).

Thanks for the explanation. Not wanting to sell at a low makes sense, but I still don’t see how that makes cash a superior option. If a mutual fund grows at 10% on avg, but sheds 3% the day before I need to use it as an emergency fund, isn’t that still better than a MMA that grows at 3% overall?

There’s a chance the fund grows less than an MMA over the years it’s sitting in an emergency fund, but from what I understand that seems unlikely. Am I missing something here?

I agree. With these rough financial times, I believe more people are going to realize just how critical it is to have an emergency fund. I also agree with those funds being very liquid with quick easy access. High interest savings accounts may be one of the better options. I’ve been concerned though about the safety of my safety net given the current banking crisis. I was unaware that the FDIC had changed its limits. Then I came across this at my online bank.

FDIC now insures up to $250,000 per depositor. Individual and joint accounts are insured separately, so if you have both types of accounts, your total deposits can be insured up to $500,000; thatÃ¢â‚¬â„¢s up to $250,000 in all your individual accounts and up to an additional $250,000 in your joint accounts.

Michael,
You said what you said a couple of months before the market went down. I’m assuming that you don’t feel the same way now. What you’re doing is great as long as there is a minimum of 8 months worth of expenses of “cash” available to use immediately (given that credit card balances, if any, are paid off). Put the cash in a high yield account and you can’t go wrong. It’s not a matter of “if” you would have to tap into it. These days it’s a matter of “when” it you would tap into the cash. There is truth to the saying “Cash is King!”

Until recently I’ve been discouraged by the idea that I really needed 3-6 months in savings for an emergency. If you are in an income bracket that needs nearly all income for daily expenses this can take many years or more. However, I recently realized that this is not the case for some people, including my family.

Here’s my reasoning…

The 3-6 months is generally for covering a period of unemployment. However, if this happens I would get unemployment covering 60% of income. I wouldn’t need to contribute to my 401k during unemployment so that would cover another 10-15% and I wouldn’t have to pay FICA or medicare on unemployment wages which would save another 7.65%. I wouldn’t be contributing to my HSA, which is another 5-6% of gross income. So even without drawing from savings, I would have from 82-89% of my income covered. If I ate beans and rice and didn’t buy anything new for a few months I could probably get by without another 10% of my income temporarily. This means that I would only need to withdraw 10% of my normal income from savings. Even if I were unemployed for 6 months, I would still only need about 1 months take home pay to get by. Of course, higher income people would get less from unemployment, but they shouldn’t have as much trouble saving.

Renters will need less emergency funds than homeowners and you should look at your health insurance to determine what your deductible and out of pocket maximum are. Your emergency fund should be the greater of any of these needs. In my case that’s only 3000k or 1.5 months take home pay, not 3-6 months. I’m sure we would all like to have more in savings, but for those of us just getting started with our financial picture, I think it’s better to be realistic. I could fund this with just a couple of years of tax refunds. 6 month of income would take me about 8 years.

What do you think about the size of emergency fund you need? Would you set aside more or less?

I totally agree Natalie. We are in the same boat. I am a SAHM and my husband works for a non-profit organization. We have only a little left over each month, which we are applying to credit card debt. We have 1,000.00 for an emergency fund (left over income tax from this year). Anything above that will require income tax refunds annually. It is never too late to start a plan and turn things around. Last year I got a (very) part-time job, but it helps. Our goal is to do our best to apply ALL of that money to debt and savings. It is tough, but if you track expenses closely, it can be done. In a perfect world we would have boo-koos of money in retirement, savings, and be debt free by 35. However the reality is I have 2 in diapers, and I just paid 4.00 a gallon for gas.

I’d still aim for at LEAST 3-6 months, especially if you depend on your job for your health insurance. I speak from experience here: what happens if you lose your job due to illness? You can continue with COBRA, but you can end up covering the entire cost (plus small administration fee). You could strike out on your own and try to find a different plan, but if you lost your job due to an ongoing illness or injury, odds are you won’t be able to get a cheap plan, not to mention run the risk of interruption in service (if your doctors aren’t covered by the new plan, etc.). I know laws are changing and don’t know what that means for pre-existing conditions, etc., but I’d make it a priority to save up, even if slowly, enough money to cover full health insurance premiums at the COBRA price (along with deductible, etc.). We have also discovered that long-term disability insurance can be a real pain, and you don’t necessarily see the money when you need it. I realize that it takes a long time to build up savings — we will be faced with rebuilding savings on a potentially much lower income, and that is indeed stressful — but for a true emergency, you really do need a big cushion of money. One or two months of income probably just isn’t going to do it, although it’s better than nothing, of course.

We have managed to save $60K over the last 10 or so years. I’m not sure how. We certainly are not wealthy, but we are pretty frugal. We don’t have a “plan.” We don’t have a budget and we’ve had 2 lay offs in that 10 years. We also are contributing to our retirement accounts–we have about $100K between us in those, not nearly enough given our ages, really, 46 and 49. We’re planning to beef those up this year. We have about $100K equity in our $300K home. We both drive old cars…one is 10 years old and one is 8 years old. Wonder when we will need to replace one? Now that we have our emergency fund in place, we need to start thinking about 529’s for our 3 kids…

I’m new to the “financial planning arena” (24yo) and have become really interested in saving, budgeting, saving for retirement, etc. I love your blog and really like the articles you’ve discussed. I’ve read elsewhere (from such places as: http://www.mint.com/blog/saving/does-using-a-roth-ira-as-an-emergency-fund-a-good-idea-052012/) about lumping your emergency fund into an Roth IRA (possibly a 2-birds-one-stone method?) and was curious about your thoughts. I realize the negative ‘trend’ one could get into by taking money out of your Roth IRA but I do see the argument for getting a little more ‘bang for your buck’ in an IRA while your cash is sitting around for a rainy day instead of a “high” yield savings account with an online bank. I’m also interested becasue as someone who isn’t able to place a lot towards an IRA (or emergency fund) it seems like I should scrape together and gain as much money as I can with what I have. Thanks

I’m 26 have read numerous amounts of material on what, how, why and when to save money. I also have a degree in Finance and consider myself to be in a good situation for my age. Still i dont have the right answers…I purchased my first home this past summer and have about 11,000 in my savings at the moment. I put roughly 3,600 a year into my savings and 1/2 of my annual bonus. I’m predicting that by 30 I’ll have about 30,000 in my savings. This might seem a lot, but I did it once before (that’s how I bought my house). I also contribute about 9% into my 401k which my company matches 5% of that. I guess what I’m getting at is this; life is full of surprises from what I’ve seen this far, save what you can when you can to help curve those surprises down the road. If you were to lose your job tomorrow: how many weeks/months until you can’t afford to live anymore? How many weeks/months would it take you to replace that job? Now. Are you comfortable with where you are? No? Save more. Yes? Save more just in case. Ha! The more the better. You won’t find the correct answers anywhere, it’s what you think there is not chart, no set amount. To many variables.

Would you recommend putting your entire Emergency Fund in a MMA, or investing some of it, perhaps in a ROTH IRA? I have mixed feelings about doing this, but in general it seems to make sense to take on a little risk to give your money an opportunity to grow more.

I recently got divorced and was ordered to pay $1500/month in alimony for 2 years. No biggy, I don’t mind paying it. But thank GOD I had $55K in my emergency fund that I accumulated BEFORE the marriage. Saved my grits big time. That taught me to always have a substantial emergency fund and never get married without a very strong prenup.

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